Are investors constantly wrong when valuing growth stocks?

Some fund managers have said that growth stocks are permanently undervalued, but this far from conventional wisdom.

Growth investing as an investment style has outperformed value investing for more than a decade, with many suggesting this was due to historically low interest rates, which boosted the valuations of certain stocks to record highs.

However, it could also be due to market participants systematically undervaluing quality growth companies, according to Tom Wildgoose (pictured) , manager of the Nomura Global High Conviction fund.

There’s a “business school dogma” that assumes high returns on capital will attract more money which then competes away those high returns on capital down to a point where it is no longer attractive for new money.

“What they’re really saying is – if there’s an opportunity to earn high profits, people will spend money on the assets that will earn those. Therefore the profits will be competed away,” he said.

“That is a fundamental belief amongst most investors, and what we actually find is that doesn’t really happen.”

He said the reason for this is because advantages such as barriers to entry and first mover advantages, exist in the real world. What he often finds instead is “companies that are good, stay good, and those companies that the best, stay the best”.

The result of this is that when most investors assume returns on capital will fade to average and decline, companies are priced with that assumption in mind.

However, this means that on a long-term basis, investors end up with a lot of positive surprises, according to Wildgoose.

He said: “The company ends up doing better than you think over the next 10 or 15 years because returns have not declined to the cost of capital.

“If we price a high-quality company as if it’s going to see its returns fade, we’re almost systematically undervaluing those high-quality companies because the chances are that they are going to end up doing better than we think in the very long term.”

This is one possible explanation for why the MSCI Quality index – a basket of stocks with high return on equity, stable earnings growth a low leverage – has outperformed the broader market for the past decade.

Performance of MSCI Quality v MSCI World over 10 years Source: FE Analytics

However, Alex Wright, manager of the Fidelity Special Values investment trust, disagreed with the notion that high-quality companies were systematically cheap.

“In my opinion, the market is currently systematically overvaluing growth business and their barriers to entry,” he said.

“Areas of high growth tend to attract more capital and this leads over time to erosion of market share and returns. This is especially true in today’s environment where record low interest rates mean cash available for new competitor start-ups is abundant.

“When stocks are priced for perfection, as they often are today in growth areas, the disappointment of earnings misses, from increased competition, can be badly punished leading to large stock price underperformance.”

Nick Clay (pictured) , manager of the RWC Partners Global Equity Income fund, also disagreed with Wildgoose. “The market regularly swings between love and hate with such companies,” he said. “When in love it places unachievable expectations on them via excessive valuations. See the tech bubble of 2000 and today, again the mega tech stocks.

“Yet, when hated, these same companies have also been valued as if they would cease to exist, such as Microsoft in 2013.“The market repeatedly struggles with quality companies when under some sort of controversy, doubting their ability to suffer change, and repeatedly re-rates those quality companies where all is plain sailing. At excessive valuations, even the greatest companies become the riskiest.”Dan Whitestone, manager of the BlackRock Throgmorton Trust , said that not all growth stocks were being systematically undervalued, but noted that certain companies grow for longer than most expect.“In our view, all companies should be evaluated based on the fundamental outlook for profits and cashflows, because the rewards for identifying well-financed, self-funding, growth companies can be incredibly attractive and can persist for a lot longer than people think,” he said.He said that the traditional price-to-earnings [P/E] metric used to assess a company is too simplistic, “and causes investors to miss the best investments”.“It is a very short-term metric and it tells you very little about a company’s real prospects or its ability to deliver materially higher profits over the coming years,” he argued.It often uses ‘adjusted earnings’, but many of these adjustments reveal a disconnect between the earnings and cashflow Whitestone added.As an example, he pointed to an “optically ‘expensive’” company priced at 30x […]

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